What central bankers can learn from Academics
Blinder uses the Tinbergen-Theil targets-and-instruments approach to Monetary Policy which requires that Central Bankers specify: A. The goals of policy B. The Instruments C. Their model of the macroeconomy D. Forecasts of exogenous variables A. Goals of Policy Congress directed monetary policymakers to pursue maximum employment and stable prices. Usually we take that to mean that policymakers should pursue a natural rate of unemployment, but there is no formal rule to do so. Alan Greenspan defined stable prices as when households and business decision makers no longer take inflation into account. All in all, there is a lack of consensus on the ultimate targets for inflation and unemployment, and Blinder believes it seriously handicaps rational policymaking. He believes policymaking should be less situational, and more formal and explicit. Deliberate Disinflation Strategy: The tightness of monetary policy should be apportioned to the gap between the squared difference between actual and target inflation. L = (U – U*)2 + A(∏ - ∏*)2 Academic literature assumes these variables (unemployment, alpa and inflation) to be known, but in practice, these are not so easy to determine what they actually are. Opportunistic Disinflation: Guard vigorously against any rise in inflation, but wait patiently for the next favorable inflation shock to bring inflation down (making the time needed to approach the inflation target a random variable). L = – U*)2 B + A(∏ - ∏*)2 Where B < unity so small deviations of U from U* are penalized more heavily than small deviations of ∏ from ∏*. This model indicates that a Central Banker may prefer to wait patiently for an opportunity to bring inflation down rather than shoulder the blame for engineering economic slack. Academics tend to use these quadratic loss functions for mathematical convenience, but the social loss from unemployment may grow slower, and thus the exponent should be less than 2. B. Instruments Almost all Central banks use the overnight interbank loan rate as their central policy tool (Fed Funds Rate in U.S.). Four Elements of Uncertainty about how the Economy will React to Fed Funds Rate Adjustments: 1. Market Reactions: How will the primary transmission variables (long term interest rates, stock prices, exchange rates and credit) react to changes in the rate. 2. IS Curve: How will real aggregate demand react to changes in the transmission variables. 3. Okun’s Law: How will the unemployment rate react to changes in GDP. 4. Philip’s Curve: How will inflation react to changes in unemployment. C. The Model of the Macroeconomy The Fed’s model is not just a trade secret, in a real sense, it does not exist because member of the board prefers their own models. Failure to take account of lags: 1. The central bank needs academics to come up with a way to measure the lagged “pipeline” effects of monetary policy adjustments. 2. People are impatient for the lagged effects of past action to be felt. Blinder recommends using a dynamic programming way of thinking to solve this. This involves making a hypothetical plan for your policy instrument for the entire planning horizon even though you will only actually follow the first period plan. At subsequent periods, you must evaluate new information and make a entirely new multi-period plan. D. Forecasts Few, if any banks rely heavily on econometric models to forecast. Blinder suggests longer forecasts to account for lags (though he admits forecasts over 2 periods are grossly inaccurate). RANDOM TIDBITS: Brainard Conservatism Principle: Under certain conditions multiplier uncertainty makes optimal policy more conservative. Fine Tuning the Economy: Blinder says that even a bad archer should still aim for the bulls-eye. Some people suggest that monetary policy should follow a non-reactive policy like Friedman’s K percent rule for monetary growth. Phillip’s Curve: Tradeoff between unemployment and anticipated inflation. Barro-Gordon Model: L = ( u - ku*)' + a ( r - r*)' Rogoff Solution: Have a conservative central banker Blinder adds a potentially more effective solution: Direct the Central Bank to set K=1 (i.e. to not set unemployment below the natural rate). You don’t need a CB whose personal A is high, just make rules to behave as such. Blinder's Law of Speculative Markets: the markets normally get the sign right, but exaggerate the magnitude by a factor between three and 10. If this is true, a central banker who follows the markets too assiduously is liable to overreact to current data and tacitly adopt the markets' short time horizons as his own. Maintaining a long time horizon is perhaps the principal raison d'etre for central bank independence. CONCLUSION: Monetary policy should be more conceptual and less situational. Academics have spent way too much time on a non-existent time-consistency problem. Blinder Joke: “Furthermore, making it operational for monetary policy requires a concrete definition of "doing nothing”, which has proven elusive to students of Monetary policy over the years”